Introduction to

Macroeconomics

Economic analysis
Human wants are unlimited while the
resources are scarce.
Economic theory or analysis deals with the
basic proposition of how human beings or
individual economic units behave against
the problems of scarcity and react to the
observed changes.

Economic analysis
Human beings often face problems of scarcity
and choice
The aspect of choice occurs as consumers can
satisfy only some of their wants while they have
to forgo others.
The freedom of choice gives rise to opportunity
cost, which is the next best alternative choice
that has been forgone.
Opportunity cost is the real cost of a choice and
can be applied not only to consumer choices at
the micro level but also community choices at the
macro level.
3

Economic analysis
Major focus of economic analysis is on how
individual economic units have to make a choice
among the limited resources.
Economic analysis establishes reference points
that indicate what to look for and how economic
issues are interrelated. This enables better
understanding of relationships among complex
and often unrelated economic events in the actual
world.
However, a serious limitation may emanate from
the assumptions, which form the basis of these
propositions. Therefore such assumptions must
be realistic so as to serve the purpose of
understanding economic issues and propositions
4

Session Outline

Classification of economics
Development of macroeconomics
Basic concepts of macroeconomics
Policy instruments
Diagnosing health of the economy
Circular flow of income

Classification of Economics
Positive and Normative Economics
Macroeconomics
Microeconomics

Development of Macroeconomics
Microeconomics deals with the behavior of
individual entities like individuals, markets,
firms, households, etc.
Thus it looks into the micro aspects of the
economy, whereas macro economics
studies the broader aspects of the
economy and studies the behavior of an
economy as a whole.
7

Development of Macroeconomics
Keynes pioneered a new approach to
macroeconomics and macroeconomic
policy.
Any discussion on macroeconomics starts
with J M Keynes, the famous economist.

Development of Macroeconomics
Prior to Keynes, the business cycles were
considered to be inevitable, and there was no
concrete approach to solve these problems.
These economists known as Classical
economists focused only on the micro aspects of
the economy. The Great Depression of 1930s
left many of these economists helpless.
In this backdrop, Keynes came up with a new
approach to look at the economy. In his book,
'The General Theory of Employment,
Interests and Money'.
9

Development of Macroeconomics
Keynes argued that it is possible that high unemployment
and underutilization of the capacities may take place and
continue in the market economy. He also argued that
government can play a bigger role during the economic
depressions by effective utilization of monetary and fiscal
policies.
After the World War II, the focus of economics was just
aimed at countering unemployment and inflation, and some
economists proposed a fixed money growth rate to address
these issues like inflation and unemployment. Hence these
economists were called as monetarists as they have given
importance to money.
10

Development of Macroeconomics
In the last few decades, another school of
thought has gained prominence among noted
economists. These economists opine that
people should be given enough incentives for
their earnings, rather than imposing taxes on
their earnings. This group of economists
advocates incentives for savings, known as
supply side economists.

11

The Goals of Macroeconomic

Policy

Full employment
High living standards
Price stability
Reduction of economic inequality
Rapid economic growth
Steady foreign exchange position

12

Full employment

13

Full employment
The effect of this macroeconomic indicator is
directly felt by the individuals. It is imperative on
any government that it should ensure full
employment to the citizens of its country.
Unemployment rate shows different patterns in
different phases of business cycles. In the given
figure , it can be seen that unemployment rate in
the US was too high between 1930 and 1940.
During this period, the economy witnessed one
of the worst depressions.
14

High level of output (GDP)

The ultimate aim of any economy is to provide the desired
goods and services. The economy should be in a position to
offer these goods and services in ample number. To measure
the output of any economy, Gross Domestic Product (GDP) is
the most comprehensive estimate. GDP measures the market
value of the entire output in a country during a particular
year.
There are two variants in GDP- Nominal and Real. When
nominal GDP is adjusted for inflation, it gives real GDP.
The importance of GDP can be analyzed by the fact that any
predictions regarding the future growth or fall in the
economy or date on the past economic performances are
made in the GDP percentage. In the recent figures released
by the Central Statistical Organization, Indias economy grew
by 9.4%, in the second quarter of 2007.
15

Price Stability
Stable prices are the third macroeconomic
objective. Consumer price index (CPI) is the most
commonly used measure of overall price level in an
economy. CPI is the measure of the cost of different
types of goods bought by the average customer.
Inflation denotes the rise or fall in general price
level in the economy. Inflation rates, shows the
rate of change in the price index.
When the
inflation is high, the purchasing power of the
customers reduces.
A negative fall in the prices is known as deflation,
as witnessed during the Great Depression of 1930s.
Whereas, hyperinflation refers to the rise in prices
by thousands of percentage points, resulting in the
collapse of the price systems. Hyperinflation was
witnessed in Weimer Germany in the 1920s and
again in Brazil in 1980s and Russia in 1990s.
16

Sustainable Balance of Payments

Globalization has resulted in increased transactions
between a country and the rest of the world.
Balance of Payments records all these transactions,
both imports and exports. Countries keep a close
watch on their international trade.
The barometer that shows the efficiency of
international trade is the net exports. It is the
difference between the value of exports and value
of imports. Net exports are also called as the
balance of trade.
Every country desires to have a positive balance of
trade.

17

Economic growth
Every country wishes to and strives for
having a constant growth in its economy.
There are two parameters that judge the
rate of growth that an economy achieves.
Increase in production possibility curve or
schedule
Growth in GDP or per capita income

If GDP is growing at g% per annum and

population at p%, per capita GDP must be
growing by= (1+g / (1+p) - 1
18

Basic Concepts
Stocks and Flows
Equilibrium and Disequilibrium
Statics and Dynamics

19

Basic Concepts in Macroeconomics

In
macroeconomics
study,
various
variables are used. Some are stock
variables and some are flow variables.
Variables like money supply, CPI, Foreign
exchange
reserves,
which
can
be
measured at any given point of time are
called as stock variable. Whereas variables
like GDP, inflation, imports, consumption
and investment, which can be measured
only over a period of time, are flow
variables.
20

Basic Concepts in Macroeconomics

Equilibrium reflects balance between the opposing
forces, whereas disequilibrium reflects lack of such
balance.
In economic parlance, equilibrium does not mean a
motionless state; rather, here the action is more
repetitive in nature.
Economic models consist of stock and flow variables.
These can be either in the state of equilibrium or
disequilibrium at a given point of time.
Models that do not consider the behavior of variables
from one time period to another in an explicit
manner are called static models.
Dynamic models consider the movements of
variables over different time periods in an explicit
manner.
21

Diagnosing Health of the

Economy

National Product and Domestic Product

Aggregate Consumption
Gross Domestic Savings
Gross Domestic Capital Formation
Wholesale Prices, Consumer Prices and
Inflation
Employment
Balance of Payments
Rate of Growth
22

Policy Instruments
Fiscal Policy
Monetary Policy

23

Fiscal Policy
Fiscal policy is concerned with the use of taxes and
government expenditures. Government has to meet various
expenditures like salaries, defense expenses, infrastructure
development, etc. Another part of government expenditure
also goes in the form of transfer payments like financial
assistance to the elderly and unemployed. All these expenses
leave a positive effect on the overall economy. The impact of
government spending is also felt on the overall spending in
the economy, thus influencing the size of the GDP.

24

Fiscal policy
The other part of the fiscal policy is generation of
revenues for the government. Taxes are the main
source of revenue for any government. Taxes
affect the economy and the individuals in two
ways. First, taxes imposed on the income of the
people bring down the disposable income in the
hands of the consumers. This reduces the
spending in the economy. Second, the taxes
levied on goods and services make them costlier.
This discourages the firm to invest in capital
goods.
25

Monetary Policy
Monetary policy is the second most widely
used macroeconomic policy instrument.
Monetary
policy
helps
government,
managing the nations money, credit, and
banking system. There are various entities
that are part of the monetary system of an
economy. Central bank regulates the
monetary system, and other entities like
banks, insurance companies, NBFCs are
also a part of the monetary system.

26

Monetary Policy
In India, Reserve Bank of India is the
custodian of the monetary system of the
economy. Central bank brings changes in
the interest rates, reserve requirements,
etc. These changes make significant
impact on the overall functioning of the
economy.
For example, the lowering of interest
rates on housing loans helped the growth
of the housing sector. As a result of low
rate of interest, it became easier to avail a
housing loan and to own a house. This has
resulted in the growth of many allied
industries as well.
27

Exchange Rate Policy

Exchange rates are determined by the
demand and supply functions.
India follows a flexible exchange rate
policy, which is determined by the demand
and supply, where RBI has a right to
intervene in the market. In order to
regulate
the
foreign
exchange
transactions, government has come out
with an act FERA, which was replaced by
Foreign
exchange
management
act
(FEMA).
28

Employment Policy
Employment policies are adopted by
government in order to increase the
employment level in the country. As
a part of this policy, governments
come out with various polices.
For example, in India, government has
introduced various policies and schemes
like, Jawahar Rozgar Yojna etc.

29

Price and Incomes Policy

This policy aims at regulating the prices in
the market and also to ensure the
minimum wages to the workers.

30

International Trade Policy

Globalization has given a big push to the international
trade. This has resulted in framing of specific polices by
many countries to cope with the new challenges.
International trade policy addresses issues like tariff and
non tariff barriers.
In line with the changing economic scenario, government
came out with export-import (EXIM) policy in 1997. The
policys primary aim is to increase the exports. It has been
renamed as foreign trade policy to reflect the new
approach.
Example: The recent policy announced in January 2006
has taken up a series of policy initiatives to fine tune the
policy 2002-07. The policy aims at bringing down the
transaction costs, accelerating the exports and making the
country a manufacturing hub for quality goods and services.
SEZs to promote not only manufactured goods but also
agricultural products. Special emphasis is placed on
exploiting Indian Labour skills to further exports.
31

The Circular Flow of Income

Two Sector Economy
Closed Economy
Open Economy

32

Two-Sector Economy
(When All Income is Consumed)
Wages and Profits
(i.e. income (Y)
Rs.1000

Household
Sector

Productive
Sector

AtEquilibrium :
Y AD
AD C
Y C

Private
Consumption (C)
Rs.1000

33

Closed Economy
Wages and
Profits (i.e.
income (Y)
Rs.1000

AtEquilibrium :
Y AD
Household
Sector

Productive
Sector

AD C S C I
InEquilibrium
SI

Private
Consumption
(C) Rs.800
Investment
Rs.200

Savings (S)
Rs.200
34

Open Economy
Wages and Profits
(i.e. income (Y)
Rs.1000

Household Sector

Productive Sector

Private
Consumption (C)
Rs.800
Investment (I) Rs.80
Exports (E) Rs.60
Government
Expenditure (G)
Rs.60
[Injections (J)
Rs.200]

AtEquilibrium :
Y AD
Y C I G X
C J

Savings (S) Rs.100

Imports (M) Rs.50
Taxes (T) Rs.50
[Withdrawals (W)
Rs.200]

35